Washington, DC- As students of law, business and public policy, you have an interest in real life case studies that combine financial markets and policy issues. Current developments in the housing and mortgage markets provide such an example. I will spend my time this morning reviewing the current state of the housing and mortgage markets, the implications for our capital markets and economy, and the role government and the private sector should play as we go forward.

The ongoing housing correction is not ending as quickly as it might have appeared late last year.

And it now looks like it will continue to adversely impact our economy, our capital markets, and many homeowners for some time yet. Even so, I believe we have a healthy, diversified economy that will continue to grow.

The housing correction has its roots in an eight-year period of exceptional home price appreciation which was fueled by an increased demand for, and an abundant supply of easy credit. Speculation also played a significant role, as the share of buying activity by investors or individuals buying second homes more than doubled from 2000 to 2005. Homebuilders responded to the extraordinary demand for more and larger homes as if it would last forever.

As mortgage lenders and investors reached for higher returns this """"demand"""" pressure, coupled with our fragmented mortgage origination process, led to a decline in underwriting standards and a sharp increase in the issuance of riskier mortgage products. As demand for housing began to slow in 2004, originators, eager to maintain high mortgage origination volumes, further lowered their underwriting standards.

While adjustable-rate mortgages (ARMs) are not new, recent years saw an increase in hybrid-ARMs with low teaser rates, interest-only features, low- or no-down payments, and even negative amortization. In fact, about one-quarter of mortgage originations were non-traditional ARMs in 2005 and 2006, exposing mortgage holders to much greater risk than the traditional 30-year fixed rate mortgage with a 20 percent down payment.

This decline in lending standards was not limited to, but was most pronounced, in the case of subprime lending, which grew from only about 2 percent of mortgages in 1998 to nearly 14 percent in mid-2007. A significant percentage of the non-traditional ARMs were marketed and sold to subprime borrowers. Predictably, the result has been progressively higher rates of default on subprime mortgages.

The inevitable correction began in early 2006. Today, average nationwide home prices are barely up in the year through June, sales of existing single-family homes are down by nearly 25 percent from the peak in 2005, and the inventory of unsold homes has increased to levels last seen in the early 1990s. Housing should be analyzed by local or regional markets; averages can be misleading. Areas with the greatest price appreciation prior to the correction, such as Las Vegas, San Diego, central California and a number of cities in Florida, have seen declines. And prices are falling in other parts of the country where economic growth is slower, such as Michigan and parts of Ohio. Working through the housing correction will continue to take time.

As I mentioned earlier, mortgage defaults and foreclosures are rising. While the delinquency rate today is near the 2001 rate, there are over seven times more subprime mortgages today than there were in 2001. At the end of the second quarter of this year, more than 900,000 subprime loans were at least 30 days delinquent. Foreclosures are also up significantly – increasing about 50 percent from 2000 to 2006. Foreclosures on subprime loans are up over 200 percent in that same period. Current trends suggest there will be just over 1 million foreclosure starts this year - of which 620,000 are subprime.

Of the approximately 50 million outstanding mortgages in the U.S. today, approximately 10 million are subprime loans. Many have cited the statistic that 2 million of those subprime mortgages will reset to higher rates in the next 18 months. That statistic is true, relevant, and troubling, but it is not the complete picture of the risk going forward. Many of those borrowers will be able to afford their new mortgage payment or they will be able to refinance into another more affordable mortgage. Yet, the problem today is not limited to subprime mortgages as the number of homeowners having trouble making payments on prime mortgages is also increasing. And finally, the wide geographic variation in home price trends adds to the complexity of sizing this problem with any certainty.

While innovation in the mortgage sector has brought benefits to our economy, the industry and homeowners, it has also introduced some challenges. Gone are the days when a homebuyer only went to the corner bank to take out a mortgage. Today, the mortgage process is disaggregated and less personal. A mortgage loan is likely to be originated, serviced, and owned by three different entities. Originators often sell mortgages to securitizers who package them into mortgage-backed securities, which are then divided and sold again to a global network of investors.

In today''s decentralized system, a homeowner having trouble making payments often does not know where to turn for assistance.

In addition to affecting individual homeowners, the housing correction is also having a real impact on our economy. Annual housing starts peaked at an annual rate of almost 2.3 million units in early 2006 before falling off more than 40 percent through August of this year. Employment in residential building, including specialty trade contractors, has dropped by almost 200,000 since early 2006, offsetting about one-quarter of the jobs gained in the housing boom. It looked like housing construction had reached a bottom in the first half of this year, but starts have declined again since June and data on permit applications and inventories of unsold homes suggest further declines lie ahead.

We confront these current challenges against the backdrop of a strong economy – not just in the U.S., but globally. Indeed, this is the first housing downturn in the past three decades in which U.S. GDP growth has not turned negative. Business investment has expanded in recent months, our exports are being boosted by the strong economic growth of our trading partners and the healthy job market has helped consumer spending continue to grow.

But let me be clear, despite strong economic fundamentals, the housing decline is still unfolding and I view it as the most significant current risk to our economy. The longer housing prices remain stagnant or fall, the greater the penalty to our future economic growth.

So where do we go from here and what is the proper role for government?

First, our immediate concern must be for struggling borrowers whose primary residence is at risk. We must help as many able homeowners as possible stay in their homes. Foreclosures are costly and painful for homeowners. They are also costly for mortgage servicers and investors. They can have spillover effects into property values throughout a neighborhood, creating a downward cycle we must work to avoid.

Second, we must minimize the impact of the current downturn on our economy, recognizing the tension between such actions and the possibility of moral hazard.

When investors are relieved of the costs of bad decisions, they are more likely to repeat their mistakes. I have no interest in bailing out lenders or property speculators. Still, we must recognize the very real harms to families affected by the housing downturn. We must take steps to minimize the neighborhood effects and the macroeconomic effects of this housing market correction.

Third, we need to identify public policy changes that will reduce the likelihood of repeating some of the excesses of recent years while maintaining access to credit for able homeowners.